A Major Problem with ESOPs is That Employees Can Lose Big

Dec 10, 2024

Employee Stock Ownership Plans (ESOPs) have long been touted to align workers’ interests with their employers. The idea is simple: give employees a stake in the company, and they’ll be more motivated to help it succeed. However, a major problem with ESOPs is that they can leave employees vulnerable to significant financial losses, especially during market downturns.

The Risks of Putting All Your Eggs in One Basket

One of the most significant dangers of ESOPs is that they often encourage employees to concentrate their investments in a single company. As the saying goes, “Don’t put all your eggs in one basket.” Yet, that’s precisely what many ESOP participants end up doing. According to a National Center for Employee Ownership (NCEO) study, the average ESOP account balance in 2020 was $134,000, representing a substantial portion of many employees’ retirement savings.

When the company does well, this concentration of wealth can pay off handsomely. However, employees can see their hard-earned savings evaporate when the company struggles. The dot-com bubble of the early 2000s and the 2008 financial crisis provide cautionary tales. During these market downturns, many ESOP participants saw the value of their accounts plummet, leaving them with little to show for years of loyal service.

The Perils of Illiquidity

Another major problem with ESOPs is that they are often highly illiquid. Unlike traditional 401(k) plans, which allow participants to diversify their investments across mutual funds and other securities, ESOPs typically invest solely in company stock. This lack of diversification can make it difficult for employees to access their money when needed. According to a 2021 Employee Benefit Research Institute study, 59% of ESOP participants had more than 20% of their retirement assets invested in company stock, compared to just 5% of 401(k) participants.

This concentration of assets in a single stock can be hazardous for employees of smaller, privately-held companies. In these cases, there may be no readily available market for the company’s stock, making it nearly impossible for employees to sell their shares. For example, in the case of the now-defunct New England grocery chain Market Basket, employees who participated in the company’s ESOP found themselves unable to sell their shares when the company was embroiled in a bitter ownership dispute in 2014.

Moreover, even when employees are eligible to sell their shares, they may find that few buyers are willing to take them off their hands. This illiquidity can be particularly problematic for older workers nearing retirement who need to convert their ESOP holdings into cash. According to a 2020 report by the Government Accountability Office, nearly 40% of ESOP participants aged 60 and older had more than half of their retirement savings invested in company stock, putting them at risk of significant losses if the company fails. This lack of liquidity can force older workers to delay retirement or accept a lower standard of living in their golden years.

Lessons from Market Downturns

History is littered with examples of how market downturns can wreak havoc on ESOPs. During the 1987 crash, for instance, the value of many ESOP accounts plummeted by 30% or more in a single day. The dot-com bubble of the early 2000s was even more devastating, with some ESOPs losing 90% or more of their value.

More recently, the COVID-19 pandemic has highlighted the risks of ESOPs in industries particularly vulnerable to economic shocks. According to a survey by the NCEO, nearly 40% of ESOP companies in the hospitality and retail sectors reported that the pandemic had a “severe” impact on their business, compared to just 17% of ESOP companies overall.

The Power of Contrarian Investing

So, what can employees do to protect themselves from the risks of ESOPs? One strategy is to embrace the power of contrarian investing. As Warren Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.” In other words, the best time to buy is often when everyone else is selling, and vice versa. This approach can be particularly practical during market downturns when stock prices are depressed, and fear is widespread.

Consider the example of Southwest Airlines, which has long been known for its employee-friendly culture and generous ESOP program. During the 2008 financial crisis, when many airlines struggled to stay afloat, Southwest employees voluntarily took pay cuts to help the company weather the storm. As a result, Southwest could avoid layoffs and emerge stronger from the crisis than ever. Employees who held onto their ESOP shares during this period were richly rewarded when the stock price eventually rebounded.

Another example of the power of contrarian investing can be seen in the case of Publix Super Markets, an employee-owned grocery chain based in Florida. During the COVID-19 pandemic, when many businesses struggled to stay afloat, Publix saw a surge in sales as customers stocked up on essentials. Despite the challenges posed by the pandemic, Publix’s stock price increased by more than 20% in 2020, rewarding employees who held onto their ESOP shares during the crisis.

Of course, contrarian investing is not without its risks. A major problem with ESOPs is that employees who buy shares during a downturn may see the value of their investment continue to decline if the company’s fortunes do not improve. However, employees can increase their chances of coming out ahead in the long run by taking a long-term view and investing in companies with strong fundamentals and a track record of success.

The Benefits of Technical Analysis

Another way to mitigate the risks of ESOPs is to use technical analysis to inform buying and selling decisions. Technical analysis involves studying charts and other market data to identify trends and patterns that can provide clues about future price movements.

For example, an employee considering selling their ESOP shares might look for signs of weakness in the company’s stock price, such as a breakdown below a key support level or a bearish crossover in a moving average. Conversely, an employee considering buying more shares might look for signs of strength, such as a breakout above a resistance level or a bullish trend line.

By combining technical analysis with a contrarian investing approach, employees can make more informed decisions about when to buy and sell their ESOP shares. For instance, an employee might use technical analysis to identify an oversold stock and then use a contrarian approach to purchase shares when everyone else is selling.

The Wisdom of the Ages

Of course, no investment strategy is foolproof, and ESOPs are no exception. As the philosopher Heraclitus once said, “The only constant in life is change.” Markets are constantly evolving, and what works today may not work tomorrow.

That’s why it’s so crucial for ESOP participants to stay informed and to be willing to adapt their strategies as needed. As Mark Twain famously quipped, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that ain’t so.”

Ultimately, the key to success with ESOPs is to approach them with a healthy dose of scepticism and a willingness to think for oneself. As legendary Benjamin Graham once said, “The intelligent investor is a realist who sells to optimists and buys from pessimists.”

By embracing the power of contrarian investing, using technical analysis to inform buying and selling decisions, and staying attuned to the wisdom of the ages, employees can navigate the risks of ESOPs and come out ahead in the long run. It won’t be easy, but nothing worth doing ever is.

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